Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Search

Search

Subscribe via e-mail

Disclaimer

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Peak Credit

What I write here will not be rigorous. We’ve heard about “peak oil.” We’ve heard about other resources, and how production will decline over time.

But what of credit? It isn’t that hard to create, but it is hard to create well, particularly when debt levels are high, as in this environment.

It’s not just the US, debtor-friendly as it has been for most of its existence. Most of the rest of the world has debt problems.

China has indebted municipalities and banks, and debts to many projects from Party members that will not pay off. The EU is overly indebted everywhere, not just the PIIGS, and finds its overall borrowing rates rising as lenders wonder what a Euro will be worth if the Eurozone dies.

In the US, government debt rises more than corporate and consumer debt falls. We’ll pay the government debt off later. Don’t worry. 😉

The simple solution to every problem is to say the it is a liquidity problem, not a solvency problem. How do does one solve a liquidity problem? Get a loan. If the assets are really worth more than the liabilities, there should be some unencumbered assets that you can secure a loan with, and pay off the liquidity squeeze. But absent that, it’s insolvency, regardless of what notional price one places on the assets.

But what if the problem is really a solvency problem? Will a loan help cure that? No. You can’t solve a debt problem with debt.

There are generally few liquidity problems relative to solvency problems. As an example, most corporate bonds don’t default on principal payments, but on interest payments. For individuals, balloon payments on loans might be relatively more of a problem, but since most people finance their homes, etc., on relatively thin ratios of income to debt service, interruptions of income lead to insolvency more often than balloon payments.

Consider for a moment that every liability is the asset of someone else, but not vice-versa, because some assets are owned free and clear. Now pretend that we take everything in the world (the same could be applied to a nation), and put it on a single balance sheet, but we don’t net out the liabilities that would cancel out.

Which system would be more stable? One where the liabilities are roughly equal to the net worth, or one where they are roughly five times the net worth? The former, of course. Now, not all liabilities are the same — long-dated claims like pensions only claim a little bit of the assets of the world at a time, whereas a large number of short-dated liabilities would make the system less stable, or perhaps lead to inflation. Many dollars chasing few goods, or assets, or both.

I’m not sure exactly where the boundary line is for “peak credit.” It would depend on the structure of the liabilities in question. But once the fuzzy limits get exceeded:

Growth can slow. (Think of the book, “It’s Different This Time.”)

Debt deflation may arrive. (Extend, Compromise, Default)

Inflation may arrive for assets, goods, or both, depending on the propensity to save versus consume.

And, if the debt gets high enough, and immediate enough, any entity may hit the “tipping point” where the market concludes that it is no longer possible for the entity to pay off its debts. Short-term rates skyrocket, and the prices on long debt discount expected recovery levels. For countries with their own currency, it may involve a lot of inflation, though a negotiation with creditors might be simpler.

In general, if we were starting over again, there are a lot of things that we should have done differently:

Dividends would be deductible, and not interest.

This would apply to all personal and corporate interest, including mortgages.

We would eliminate the GSEs, and all government lending programs.

We would run balanced budgets as a nation, and live with the modest volatility that induces. We would not engage in fiscal stimulus.

We would eliminate or constrain the Fed, such that it could never let the difference between ten and two year Treasury yields exceed 1.5%, or be less than -0.5%. We would let recessions do their work of eliminating bad investments, because if you don’t, you end up with the debt deflation we are facing now.

Or, go back to a gold standard, after analyzing what the proper value for the dollar would be, so as to avoid inflation or deflation.

We would constrain banks to match assets and liabilities, and not engage in maturity transformation.

Banks would be a lot less profitable under such an arrangement, but it would prevent debt bubbles. Besides, the banks would make up for it by charging for deposit/checking accounts.

Summary

We may be near “peak credit” at present, and that is true of much of the world. Better we should have had a smaller financial sector, and avoided the financialization of the economy. As it is, we face many years of slower growth ahead as we bleed debt out of the economy, or a number of years of inflation ahead, as we inflate away debts. I suspect the former, but I can’t ignore the latter.

About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →